10/9/2012: Insane path of Irish 'wealth'

Another interesting chart from the IMF reports today:

Now, look at the red line - Net Wealth in Ireland, which has dropped to levels below those in Q1 2002, while housheolds' total taxes (VAT and Income taxes combined, excluding other) has ballooned from €17.96bn in 2002 to €23.54bn in 2011. So let's do a simple mental exercise: net wealth is down ca 30%, household taxes are up ca 31%... and we are supposed to:

• Deleverage our own debt
• Deleverage the banks-related debts of the Exchequer

What a better illustration of madness can one find? Oh, wait, I know - the Armchair Socialists' one: "Ireland is a very wealthy country and we must tax wealth to extract funds for the Government". Alas, we are rich... rich as we were more than 10 years ago. Since 2002, folks, it's not the wealth of ours that grew, but the appetite of the State for our wealth.

1/8/2012: Sunday Times July 29, 2012

An unedited version of my Sunday Times article from July 29, 2012. Please note - this is the last article for the Sunday Times for at least some time to come.

As markets attention shifted from the issues of economic growth to the more immediate crises in Spain, Italy and, once again, Greece, our policy-makers have been basking in a rare spot the sunlight. This week, Irish Credit Default Swaps – insurance contracts on Government bonds – have traded out of the range of the top-10 highest risk economies in the world, for the first time in a number of years. The core driver for this was not something that happened in Ireland, however. Accelerating costs if insuring Italian bonds, helped by margins hikes and ratings agencies warnings, plus the return to CDS markets of Greek bonds have pushed out of the markets spotlight.

With improvement in Irish bonds and CDS contracts relative performance compared to our peers in the peripheral Europe, it has been all too easy for Irish policymakers to forget that the economy is still stalled in the no-man’s land between recession and stagnation. In the short run, the news from the real economy here remain abysmal. But more worryingly, the news continue to reinforce the reality of the entire crisis, compounding already disastrous declines in household wealth, pensions, income and jobs prospects. This compounding means two things for the future. In the near term, it spells no prospect for a recovery in the domestic side of the economy. In the longer run they mean decades of depressed economic growth and a massive black hole of Ireland’s Lost Generation – those born in the late 1960s and into the early 1990s.

The future is truly bleak for the generations of the 30-50-year olds due to the historically massive debt bubble implosion that severely impacted their family balancesheets. The future is grim for today’s 20-year olds who have entered their careers amidst the recession.

Here are the facts.

Irish residents of the cohort of 30-50 years of age are the ones who are carrying the main weight of the household debt accumulated during 2000-2007 period when they either entered the property markets or traded up. According to the data trickling from the banks, these are the families that vastly (some 80% plus) dominating the ranks of high Loan-to-Value Ratio mortgages written against the property valuations that have all but collapsed. This week’s data release by the CSO shows that, measured using mortgages drawdowns, Irish property prices have fallen now 50% on average and 56% in Dublin compared to their peak. Property prices now stand at 35.2% below 2005 levels in terms of comparable data, and are closer to 2000-2001 levels – nominally – based on non-CSO data. And all signs are, the prices are yet to find their bottom.

Using Central Bank data on outstanding credit for house purchases, the implied loss in household wealth relating to the current crisis is currently running at over €90 billion. Taking into the account downpayments, stamp duty and VAT expenditures incurred by the households in purchasing their homes, the true volume of economic losses in the system is closer to €120 billion.

In a normally functioning economy, correcting for the bubble by assuming that house prices appreciation should be running on average at the rate of general inflation, Irish households – purchasers of homes during 2001-2007 period – should have had their net worth rise by a cumulative of ca €45 billion, providing an average retirement support of roughly €35,000 per person in the cohort of 30-50 year olds.

Put differently, even if we cancel out the entire negative equity component of current mortgages, Irish households would require a decade of savings (in excess of debt and remaining mortgages repayments) at roughly 10% annual savings rate to recover the amounts of pensionable wealth they have lost since the onset of the crisis. Adjusting for higher current and future taxes, increased risk of unemployment, and expected higher mortgages interest costs once the extraordinary ECB measures to support liquidity in the euro area banking sector are wound down, Irish middle-age middle class households have been thrown back decades in terms of their ability to finance pensions.

The effects of these wealth declines, however, imply that younger generations will also feel tremendous burden of the crisis. Here is how this intergenerational contagion works.

Firstly, absent pensions provisions, current 30-50 year olds will be delaying their retirement, preventing upward mobility of earnings and career prospects for the younger workers. Secondly, even prior to the crisis Irish pensions system was grossly underfunded with the country facing some of the largest unfunded future liabilities bills in the OECD. These liabilities represent the costs of maintaining current levels of public health, pensions and social welfare provisions commitments under the existent tax system. They do not account for the private pensions shortfalls.

The crisis most likely raised these costs by a significant percentage as pensions-poor households will be forced – in years to come – to rely more extensively on public system. Today’s younger workers will be paying for this through their taxes directly, while indirectly facing additional costs in terms of reductions in expected future benefits. Thirdly, international evidence clearly shows that younger workers entering their careers at the time of a recession experience on average depressed levels of life-time earnings and elevated levels of future unemployment.

It might fashionable today in the Irish media to talk about banks’ customers vs taxpayers squeeze in relation to the high cost of adjustable rate mortgages and trackers subsidization. The reality of our collective insolvency runs much deeper than the immediate crisis within the banking sector. Take a simple exercise in projecting future losses on life-time earnings for current generation of the 20-30 year-olds. On average, these workers could have expected their life-time earnings decline by 8-10 percent compared to those of workers entering the workforce outside a normal recession. At current average earnings, the overall life-time income losses that can be expected by the younger generation amount to some €145-180,000 in current value terms. Per Census data for 2006 population distribution, and using the CSO projected labour force participation rates through 2041, the above range implies a cumulative loss of earnings to the tune of €64-117 billion for the economy as a whole.

Pair these earnings losses for the younger generation with the wealth declines experienced by the middle-aged cohorts and the Lost Generations of Ireland are now on track to a full-blow intertemporal bankruptcy. Both, psychologically and economically, this is a truly disastrous legacy of the boom. And this legacy remains largely hidden behind the rhetoric of our politicians and the media pretending that the negative equity, the wealth destruction and the long-term consequences of the Great Recession will be gone once Ireland’s economy returns to growth. Truth is – the Lost Generations are already here. And they are us.

Box-out:

It appears that the euro zone authorities are frantically pushing through the latest magic bullet solution to the Euro area sovereign debt crisis – the promise of a banking license for the European Stabilization Mechanism (ESM) fund. As conceived, the ESM will have lending capacity severely restricted by the capital held. The banking license, it is argued, will allow the ESM to borrow cheap funds from the ECB (just as the commercial banks are currently doing) and lend these funds out into the distressed banking system for recapitalization of troubled banks. The theory goes that while the markets will not accept leveraging of the ESM capital in excess of ca 7:1, the ECB will have to lend to a ‘bank’ and this can raise the ESM total effective lending capacity from €500 billion to €1 trillion. The problem, of course, is that as with all other previous ‘magic bullet’ solutions, the latest idea is likely to have more disastrous unintended consequences than the original problem it tries to address. Under normal operations the ECB does not lend unlimited amounts to any given bank and when it does lend, the loans are less than 12 months in duration. Thus, should the ESM attempt to borrow via a banking license from the ECB, the entire euro area monetary system will become a farcical cover up for indirect and vast lending to the banks and the sovereigns of the euro zone. Hardly a hallmark of a responsible, and reputationally and legally well-run monetary policy.

Economics 24/08/2009: Wealth effects in Ireland and Wholesale Prices

Mountain air and thunderstorms are conducive to light reading, so I was wading through an interesting and sweetly short ECB paper from May 2009, titled “Euro Area Private Consumption: Is There a Role for Housing Wealth Effects”.

The paper looks at a number of Eurozone countries – excluding the wonderland of Ireland (so it provides conservative estimates for the wealth effects) – to find that the marginal propensity to consume out of financial wealth (MPCF) in the Eurozone ranged between 2.4% and 3.6% on the aggregate. The MPC out of nominal housing wealth lies between 0.7 and 0.9%.

Re-parameterizing the model for the case of Ireland,

• financial wealth declines since 2007 peak imply that Irish consumption should have fallen by ca 1.9-2.9%;
• housing wealth declines add another 0.35-0.45% to the consumption losses;
• while negative equity effects (assuming 20% of households in negative equity) subtract further 0.69-1% off our consumption.
• So the cumulative effect of recent wealth losses should be in the area of 1.45-2.1% of consumption expenditure.

The above figure does not account for the fact that in most cases our debt levels used to finance financial and housing wealth acquisitions were not diminished over the last two years. Factoring this in, net decline in consumption expenditure should be around 1.7-2.6% in permanent terms.

This goes some ways to highlight the fact that this economy is not running a tax-shortfall-driven deficit on public accounts – we are now increasing public consumption amidst permanently shrunken private consumption. Given that Ireland’s net current Government expenditure is projected (by the DofF) to rise 17.64% between 2009 and 2013 (from €46.365bn to €54.546bn) while the expected cumulative loss in private consumption is expected to total 8.8-13.7%, the wedge between private and public consumption growth in the crisis years is likely to be around 17.5-22.5% of private consumption. And that is before tax increases and future bonds financing burdens are factored in. In other words, tax us some more and we will withdraw all unnecessary consumption from this economy. If we were a land-locked Luxembourg, I doubt there will be many non-public service workers still living in Ireland after that.

And per the latest wholesale price indices release from CSO, here are few charts.

First, exporting vs home sales prices – a clear return to the previous trend of widening gap. Exporters are still suffering while domestic sectors are running improving pricing conditions. A brief period of convergence in November 2008 – January 2009 has now been firmly replaced by a renewed bout of falling export prices and rising domestic ones. Unfortunately, CSO is not providing actual raw data on these series this time around, so no more analysis is possible for now.

Second chart is dealing with manufacturing prices and growth rates (yoy and mom). Deflation continues here and has accelerated in July relative to June. Month-on-month changes are really telling the story – June improvement is still visible, but is being erased. Note monthly range for July 2008-July 2009 being negatively sloped, as contrasted with July 2007-July 2008. Plotting monthly indices by year shows that seasonality is not as important here and that 2009 is pretty much all about traveling down a steep deflation curve that started in November 2008.

Economics 01/08/2009: Wealth Tax

Someone asked me recently to confirm my assertion - made few months back on TV 3 programme - that a 100% tax on wealth of the Irish members of the Sunday Times Rich List 2009 will last this Government, oh, well, under 5 months.

After actually computing the total ROI-based wealth from the List and taking some adjustments, Table below shows clearly the break down of such a (extremely foolish) tax. Of course, this is a fantasy land, but it does highlight for me the idiocy of our Left wing fanatics.

As you can see, a brutish calculation puts the net take from such an exercise at a maximum of €30bn one-shot gain for the Exchequer - or an equivalent of 4 months and 22 days of Government spending (I was pretty much on target in my original statement).

Factoring in the fact that large chunk of this wealth is held by property investors and construction firms owners, whose wealth has been evaporating since December 2008 when the list was compiled and that the list reflects their wealth as assessed on last filed accounts (2007 or earlier), and taking into account that any half-sane person would diversify her holdings geographically, putting a share of her assets out of reach of the Irish Exchequer, this figure drops to €18bn, or 2 months 25 days worth of Government spending planned for 2010.

Taking into account legal costs and assets seepage during the process of collection, the entire Irish Top Rich List 2009 wealth, if it were seized by the Government, would last our Exchequer no more than 2 months and 17 days.

But, one has to take into the account the facts that:

• public spending economic multiplier is zero, while
  
• private spending multiplier is a positive number dependent on the Marginal Propensity to Consumer out of Wealth, Marginal Propensity to Invest out of Wealth-generated income, the returns to wealth and the velocity of money in this economy; and
• the fact that the Exchequer collects revenue from this wealth

all of which will be foregone if the Exchequer were to seize this wealth in one swoop.

When these factors are accounted for, the Exchequer will be covered for only 1 month and 27 days by the 100% levy on all wealth of the ROI Top Rich List 2009.

What a pack of morons represent economic arguments of the Left of this country!

Daily Economics 09/04/09: Riches in peril

Today's statement by Peter Sutherland on RTE radio concerning the alleged riches of Irish households is misleading in so far as it focuses on two mis-interpreted claims:

1. Irish GDP per capita is still on of the highest in the OECD; and
2. Irish wealth is well underpinned even despite the ongoing crisis.
   

I will tackle these in order.

Per Irish GDP per capita:

Ireland's GDP is expected to be €170-171.5bn(my forecast and DofF April 2009 forecast) in 2009. Our GNP is €142-144bn (as above). The GDP-GNP gap is standing at 16-16.5% and it is accounted for by the transfer pricing of multinational companies located in Ireland. In other words, the Dells and Intels of this world take inflated price of inputs they import into the country and then inflate value added in this country so they book more profits here. Precious little of the actual activity takes place here, but accounting shows it to be Irish-generated. This then goes into our figures for GDP. GNP excludes multinational transfers, so it is a cleaner measure of what we actually do produce in Ireland (inclusive of the real production by the multinationals).

Now, per CSO data for April 2008 - the latest we have - total population of Ireland is 4,422,100, which implies that 2009 GDP per capita is €38,443 and GNP is €32,111. There is an added trick. This does not take into the account the relative cost of living in Ireland, compared to the rest of the world. This is done by applying Purchasing Power Parity (PPP) adjustments. I don't have much recent data on PPP rates of exchange, but it does not change dramatically our position in the world rankings.

For example based on 2007 data - the latest for which global comparisons are available - we were still ranked the 3rd highest PPP-adjusted GDP per capita. However, taking PPP- adjustments to GNP and comparing ourselves with the rest of the world shows that Ireland ranked 14th in terms of PPP-adjusted GNP per capita in the world in 2007, which is, incidentally exactly where we were ranked in terms of our PPP-adjusted per capita consumption as well.

This shows two things:

1. using an actual measure of our income (GNP) instead of a bogus measure (GDP) implies that we are scoring below (in order of ranking): US, Iceland, UK, Norway, Canada, Austria, Switzerland, Netherlands, France, Australia, Sweden, Belgium, Germany and Denmark in terms of our income, and
2. that GNP per capita is reflective of our true consumption and investment positions, unlike GDP per capita.
   

Now to the second point concerning our wealth
In March issue of Business & Finance magazine I gave a detailed analysis of the wealth destruction that hit Ireland since 2008. Here is an excerpt.

“The bursting of the property bubble and of the equity bubble… showed that most of the ‘wealth’ that supported the massive leverage and overspending of agents in the economy was a fake bubble-driven wealth; now that these bubbles have burst it is clear that the emperor had no clothes…” said Nouriel Roubini in a recent update on the US economy. The same rings true for Ireland.

Two years ago, the Irish media was full of self-congratulatory patter about our riches. Our social welfare NGOs were using this myth as the grounds for demanding more welfare increases to offset the allegedly growing ‘relative poverty’. At the time just a handful of economists, this column included, were warning that our wealth was excessively geared toward one asset class – property. This lack of diversification, coupled with a lazy and often inept management of investment portfolios by the majority of Irish investors – from the most influential ones, like Sean Quinn, down to the 3-bed-semi families – is now coming to haunt us.

Nursing Real Losses
Majority of us are, by now, aware of the deep declines in housing (minus 30% plus relative to peak already and counting) and commercial (down 15% and still dropping like a stone) property values, and share prices collapse (off ca 70-80% depending on the index used). But few understand that our investments performance to date relative to other countries’ investors has been even more abysmal. This is true because of the opportunity cost of not actively managing our portfolios.

Per July 2007 Bank of Ireland report Wealth of the Nation (based on 2005 data) an average Irish investor held some 70% of gross assets in housing, 10% in cash, 8% in pension funds and 5% in business equity. Direct ownership of equity, investment funds shares and commercial property accounted for 2-3% allocations each. My own study, conducted in February 2007 on the basis of a sample of some 1,200-plus actual and potential high net worth individuals produced very similar results. In addition, it also showed that majority of Irish investors (over 72%) do not actively manage their own portfolios. Some 65% reported zero willingness to let professionals handle their investments. Instead of seeking proper advice (only 30% of Irish investors sought investment advice outside real estate agents’ offices) and acting upon well-researched information (only 43% of our savers actually searched around for best financial product offers), majority of Irish investors were keen on simply leveraging their assets as much as possible and dump most of it into high-risk property and shares deals.

Even less important for Irish investors was the idea of sectoral and geographical diversification. According to my data, only 10% of Irish retail investors held any exposure to non-property asset classes with allocations outside Ireland. Just 8% had more than 25% of their equities in non-property linked plcs.

2008 was a pivotal year in terms of changes in the Irish investment markets. Since then, factoring in the declines in asset values, the composition of the Irish wealth has been changing.

One important aspect of this change is that residential property share of overall wealth is poised to decline from ca70% in 2005 to ca55% in 2010. The latter figure is still roughly 38% above the OECD average, but the dynamic of change suggests some diversification out of property. Does this mean we are getting wiser with our money? Recently, a senior financial services professional suggested to me that because of the large pools of wealth we have allegedly held in the past, once the upturn occurs, cash will be available for investment in shares and financial funds. Sadly, I do not share his optimism.

Most of this diversification away from bricks-and-mortar is happening not because we somehow wised up to the need for diversification, but due to attrition in property values and lack of transparency in business equity valuations. In the longer term, most of this diversification will be going into increasing the importance of cash deposits implying excessively low yields in years ahead. Direct equity, investment and pensions funds and other asset classes that give investors exposure to the potential upside due to active management will remain the poor cousins of property and cash.

Using the changes in values for the main categories of assets held by Irish investors, I estimate that in 2008 Ireland’s total net private wealth has contracted by ca €150bn – from €712bn in 2005 (€805bn in 2006) to €559bn today. By my estimates, the current trend may see private net worth in this country shrinking to €307bn by the end of 2010 – a total loss of a staggering €405bn on 2005 figures. Adjusting for inflation, the total loss in wealth between 2007 and the end of 2010, by my estimates, will equal to roughly €470bn. Assuming marginal propensity to consume out of wealth of, say 3-3.5% (for US, this value is around 5%, so ours is a conservative estimate for Ireland), such wealth destruction will imply a fall-off in overall annual consumption of ca €4.8-5.5bn in 2008-2010, with a knock on loss to the VAT revenue of €900-1,100mln per annum.

A hefty opportunity cost
But this would be only half of the problem, were Irish investment portfolios actively managed through the downturn. During the current contraction cycle equity and property markets have posted unambiguously deep declines in all developed and middle-income economies around the world. However, several other highly liquid asset classes have shown relative gains. Prior to Autumn 2008, a number of international Exchange Traded Funds (ETFs) with commodities and fixed income exposures have recorded double digit dividends that would have seen the returns on these investments offsetting some of the short-term capital losses. Since late 2008, fixed income ETFs focusing on some corporate and public debt have continued to produce strong yields. Other classes of debt were also providing upsides. In many cases, such ETFs offer capital gains potential in the medium term similar to the fully diversified equities-based portfolios, but unlike equities, they pay strong current yields.

So what does this mean in practical terms? Over a dozen balanced managed portfolios blending ETFs, corporate and sovereign fixed income and actively managed money markets funds that I reviewed in recent months have been trading since September 2008. On average, this class of products has delivered a yield of ca 6-7% pa and a capital loss of 2-4%, when traded on a higher frequency basis. Compared to NASDAQ’s – 6% year to date slide, S&P500’s -13%, ISEQ’s -10.4%, accounting for re-invested dividends, some managed non-equity portfolios are returning a premium of 6-17% on average US, Asian, UK, EU and Irish indices.

In terms of the losses in Irish wealth, a switch of personal investment allocations into the actively managed asset classes (pensions and investment funds) and reversal of the direct equity holdings into an actively managed non-equity, yield-generating strategy could have saved some €1.2-3.4bn pa in wealth that is being lost due to asset allocations imbalance in Irish investment portfolios between 2009 and 2010. This is far from chop change. More active management of portfolios can generate enough savings on the investors’ balance sheets side to offset over 30% of the expected fall in our national income between these years. It can also, potentially, generate some €200-570mln in Exchequer revenues annually. The latter, of course, requires for such investment management to take place in this country – a proposition that is not exactly likely, given our poor tax treatment of investment markets and investors.

And the cost of poor governance
So enter our Government’s latest attempt at economic policy – the mini-Budget 2009 Part A. Why part A? Well, having predicted in this very column last year that we will face a new Budget by the end of Q1 2009, I can pretty much with certainty predict that whatever comes on April 7 will not be sufficient to plug the hole in the public deficit. Expect Part B some time before the end of the summer.

April’s mini-Budge will attempt to soak any PAYE earner with income above €60,000. The Government will do absolutely nothing to stimulate new investment and savings in this country. This, in turn, will lead to a double blow to our economy. First, in a series of straight jabs rapid flight of private investors’ capital out of the tax-choked economy will lead both to falling national wealth and further shortfalls in the Government revenue. Second, an uppercut of collapsing wealth will hammer pension funds across Ireland, as retail investors lose incentives to save at home and shift their longer term assets to jurisdictions with better management and more economically literate Government.

Should such scenario unfold, we’ll be lucky if our total national net assets pool does not fall below €200bn mark by the end of this recession.

Peter Sutherland is simply wrong to stress our relative wealth - just as the NGO were wrong to stress the importance of the relative poverty. The latest CSO stats on CPI - issued today - show that we are now worse off in real income terms than we were in August 2006.